The Lure (or Not) of Lower ETF Fees

By Jim Wiandt

There is no doubt that there is generally a tug of war between fund manager and investor interests. Competition and alertness are an investor's two best friends.

We find ourselves reporting on an industry that by and large (unlike - sad to say - the vast majority of the rest of the financial services business) is investor-friendly. That does not mean that there is not still going to be a tug of war between index and ETF investors getting optimal return, and product issuers and service providers defending their own bottom lines.

It's somewhat ironic that an ETF industry that was built much more on the faith that ultimately smart money will flock to quality and that this dynamic over time beats marketing, has become more focused on marketing and sales over time (as assets have grown). Oftentimes now (and is this a big surprise?) it seems like the emphasis is more on optimizing manager profits than optimizing investor returns.

Obviously it is NOT a zero sum game. If you make better-managed, better-returning products, then more assets will flow into the funds, and everyone will be happy. But as scale has grown in the business, it's clear that there HAS been some zero sum. If a family of funds has a large amount of assets and considers scaling back fees, the analysis is not going to be on what's "fair," that is for sure. It's going to be about "in which scenario will we come out with the greatest profits?"

In other words, if a fund manager is going to trim expense ratios by 10 basis points, they're going to make real sure they're getting it back in increased assets/market share or not do it. And when it's become generally clear that people DON'T flood into lower-fee like products as they're launched (because of tax issues, brand, confidence in managers or for whatever reason), the inclination for product issuers to lower fees decreases.

That's why we've seen ETF-issuer revenues soar even as they've enjoyed ever greater scale. Quite a few fund fees HAVE come down, sometimes TO defend a dominant market position or dissuade others from coming into the market. SPY and the iShares country funds (originally WEBS) are good examples, and a number of other funds quietly lowered fees as assets grew and completion increased.

But the rule has been to hold the line on fees once a dominant market share has been established. GLD hasn't come down, nor has EFA or EEM, despite there obviously being massive scale there. Here's that revenue list (scroll down to the second table) for the obvious candidates for scaled fee reductions.

Heather has a great add-on to this discussion with her review of a recent academic study, which suggests that even smart investors often ignore the one SURE THING about (in this case, index) funds: that fees will reduce your returns. I'd love to see a table that breaks down the fee differentials, demographic breakdown, by choice, etc. in that study. Very interesting. And it suggests that even in the most obvious scenario (index funds which have largely become commodities), many investors hardly look at fees. You'd think it would have to be the FIRST thing that anyone with half a brain would look at. But apparently not. We live a very sheltered life here in Indexland...

My sense is that, as with gas prices, which seem quick to rise on news or crude oil price increases, are slow to come down, these fees WILL ultimately be forced down by the massive scale of the industry and competitive pressure, because now we've got a number of major league competitors in the space who all have quality AND scale - it will just take some time.

Ultimately, I think our faith is well-placed in that competitive dynamic. We've got it good as investors already, and I think we'll only increasingly be sharing the spoils of success with an ETF industry that continues to grow and leave investors with more return and efficiency that we'd have had otherwise.